Fed Raises Rate, Says Katrina Effect Is "Near-Term"

(Bloomberg) -- Federal Reserve policy makers raised the benchmark interest rate for the 11th straight time and signaled they may do so again, saying the U.S. economy faces only a ``near-term'' setback after Hurricane Katrina.
The Fed raised the overnight bank lending rate a quarter point to 3.75 percent, the highest in four years, after meeting today in Washington. Fed Governor Mark Olson voted against his nine colleagues in favor of holding the rate steady, his only dissent ever against a rate move and the first since June 2003.
``Widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production and employment will be set back in the near term,'' the Fed's statement said. ``It is the committee's view that they do not pose a more persistent threat.''
The decision shows the Fed, in the waning months of Chairman Alan Greenspan's term, is foremost concerned about potential inflation from energy prices. About 20 percent of the 111 economists in a Bloomberg News survey predicted the Fed might skip an increase today because of risks the economy would slow.
``The bottom line: The strategy of gradually raising interest rates is not over, and unless the economy softens materially, more quarter-point hikes can be expected,'' said Lynn Reaser, chief economist of the Investment Strategies Group at Bank of America in New York, after the decision.
U.S. stocks fell after investors said the Fed is less likely to break from raising rates, adding to concern about slowing growth. The Standard & Poor's 500 Stock Index erased a gain and fell 9.7, or 0.8 percent, at 4:17 p.m. in New York.
Measured Pace
The U.S. economy, the world's largest, was ``poised to continue growing at a good pace'' before the storm, said the statement from the Federal Open Market Committee. High productivity and low interest rates will support growth, and the Fed said it still expects to raise interest rates gradually.
``With underlying inflation expected to be contained, the committee believes that policy accommodation can be removed at a pace that is likely to be measured,'' today's statement said. The August statement called inflation expectations ``well contained.''
``Higher energy and other costs have the potential to add to inflation pressures,'' the Fed said today. ``However, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.''
Katrina is complicating matters for Greenspan, 79, as he puts his final touches on his 18-year career at the Fed before his non- renewable term as a governor ends Jan. 31. Greenspan led the central bank through an era that included the longest economic expansion and two eight-month recessions.
Hurricane Effect
The storm altered the outlook for both the economy and Fed policy after it struck the Gulf Coast on Aug. 29, causing an estimated $100 billion in damage across 90,000 square miles. It killed more than 900 people, displaced hundreds of thousands and shuttered workplaces. The storm closed ports and shut down vital oil and gas refining and production facilities, prompting economists to lower their economic growth forecasts.
In addition to raising fuel prices, the disruption to production and refining operations may make energy prices more volatile, the Fed said.
The situation created one of their most complicated scenarios for forecasting Fed policy since the current cycle of rate increases began in June 2004. The split in the Bloomberg survey about whether the Fed would raise rates or hold steady was the biggest since June 2003, when economists disagreed about how much the Fed would cut rates. Merrill Lynch & Co. was among firms predicting the Fed would hold rates steady.
Olson Dissent
Some members of Congress also had called on the Fed to pause, given concerns about the economy after the storm. ``There is no reason to raise interest rates at this point,'' Senator Orrin Hatch, a Utah Republican, said Sept. 7.
The dissent by Governor Olson, a former congressional staff member, reflects the disparity of opinion.
``Mark, above all, is honest,'' former U.S. Representative Bill Frenzel, a Minnesota Republican who is now a guest scholar at the Brookings Institution in Washington, said in a telephone interview. ``If he felt the committee was going in a direction that was not good for the economy, he would not be afraid to cast a vote in opposition to his colleagues.''
Olson, 62, was appointed to his Fed post in December 2001, for a term that expires in January 2010. He was formerly staff director of the Securities Subcommittee of the Senate Banking, Housing and Urban Affairs Committee, and he served as an aide to Frenzel from 1971 to 1976.
``While the dissent came as a surprise, we certainly wouldn't read it as evidence of any sort of a significant split on the FOMC,'' said David Greenlaw, chief U.S. fixed income economist at Morgan Stanley in New York.
Treasuries
U.S. Treasuries maturing in five years or less fell after the Fed decision while longer-maturity Treasuries were little changed on speculation the Fed will be able to keep inflation in check. Futures traders added to bets that the U.S. Federal Reserve will raise its interest-rate target at least one more time this year.
Fed officials who spoke since the storm had suggested that any slowdown in growth would be temporary, especially with large pledges of government spending in place, and that there are still inflation risks. ``I'm concerned about core inflation running at the upper end of the range that I feel is consistent with price stability,'' Chicago Fed Bank President and FOMC voting member Michael Moskow said in a Sept. 7 speech.
Inflation gauges rose last month. Producer prices rose 5.1 percent in the 12 months ended August, up from 4.6 percent for year ended July. The consumer price index rose 3.6 percent on a year-over-year basis, up from 3.2 percent the prior month. Without food and energy prices the CPI rose 2.1 percent in August, at the top of the comfort range for some Fed officials.
Energy Prices
Average pump prices for regular gasoline are about 50 percent higher than a year ago and touched a record $3.057 a gallon on Sept. 2. The price surge undercut Americans' confidence, which declined in this month's University of Michigan consumer sentiment survey to the lowest since 1992.
Consumers' expectations of inflation over the next year jumped to 4.6 percent from 3.1 percent in August, the survey said. Companies are trying to pass along part of their higher fuel bills, and that may keep fanning inflation expectations.
United Parcel Service Inc., the world's largest package- delivery company, will raise its fuel surcharge for deliveries by about 13 percent next month. Dow Chemical Co., whose products are used in everything from milk jugs to compact discs, said Sept. 15 it will seek to raise prices across its ``entire portfolio'' of chemical and plastic products.
Reconstruction Spending
Any slowdown from Katrina may be eased by increased federal spending, which could push resource use rates even higher and spur faster inflation.
``You have an economy that's running with very little slack,'' Dave MacEwen, chief investment officer for fixed income at American Century Investments, said before the announcement. ``Enormous amounts of fiscal spending'' will result in stimulus ``the economy just doesn't need.''
President George W. Bush, whose approval ratings are at the lowest of his presidency, last week promised to rebuild the Gulf region in ``one of the largest reconstruction projects the world has ever seen.''
The government has already approved $64.6 billion in assistance and Senate Majority Leader Bill Frist, a Tennessee Republican, told Bloomberg News Sept. 7 that the costs of recovery and relief efforts may reach $200 billion.
Dallas Fed bank President Richard Fisher, an FOMC voting member this year, said in a Sept. 12 speech ``it would be ill- advised for the Fed'' to compensate for the increased spending through rate policy.
Growth Outlook
The world's largest economy will grow at a 3.6 percent annual rate from July through September instead of the 4.1 percent forecasters predicted a month ago, according to the most recent Bloomberg monthly survey of 57 economists. The CPI may rise by 0.5 percentage points in the quarter to 3.5 percent, according to the forecast.
With today's action, the U.S. policy rate is 1.75 percentage points above the European Central Bank's refinancing rate, 1 percentage point higher than the Bank of Canada's overnight rate, and three-quarters of a point below the Bank of England's base lending rate.

To contact the reporter on this story:
Craig Torres in Washington at ctorres3@bloomberg.net.